Currency considerations in global equity investing

By
Dr. Lawrence G. Franko

April 23, 2014

We are often asked whether we pursue currency strategies or currency "hedges" in our equity investing.

The short answer is no, although we definitely work to understand the influences of possible currency depreciations and undervaluations — or appreciations and overvaluations — on the individual company stocks in the portfolios we oversee.

There are several reasons why our answer is generally no. One is that currency hedges are not free, even when one's forecasts are correct, and when they are incorrect, they will detract from returns.

A second reason is that, at least when currencies float freely against others, efforts to forecast (beyond the forecasts implicit in the interest differentials that determine forward exchange rates) have a very poor track record. Also, what floats in one direction during one period can easily float back in the other direction during our typical three-to-five-year holding period. Again, "hedging" would likely just add to costs.

Yet a third reason for generally avoiding hedging strategies is that the companies we invest in often undertake their own hedging programs in cases where they have meaningful exposure to currency risks, either for foreign trade transactions or due to mismatches between currencies in which sales take place and currencies in which production and purchasing costs are paid.

The main reason, however, is that equity returns (and the company cash flows and earnings that determine those returns) are only infrequently tied directly to a particular currency. A U.S. dollar is a U.S. dollar; a Japanese yen is a Japanese yen.

But a U.S. or Japanese company's future earnings and cash flows will be affected very differently by currency exchange rates, depending on whether the firm is
(1) purely domestic and competing only with domestic firms;
(2) an ostensibly "domestic" company competing in world markets as an exporter or importer; or
(3) whether the firm is a multinational enterprise facing many different sources of currency effects on its results.

Predictable relationships are rare

Just because a company is domiciled in one country and traded on that country's stock exchange does not mean that its earnings are meaningfully and positively correlated to that country's currency.

Indeed, it could be exactly the reverse: A Mexican silver-mining company may trade in pesos, but a depreciation of the peso could cause (and on occasion has caused) its earnings to explode (and its stock price to dramatically increase) as the company's dollar-denominated earnings in what is a world-traded commodity remain stable, but peso-denominated costs shrink, and a 20% devaluation turns into a much greater increase in margins because most of it goes immediately to the company's bottom line.

Hedging against a peso depreciation in that case would defeat the very purpose of an equity investment in the stock. True, were we to consider a purely domestic Mexican bank, or perhaps a toll-road concessionaire, we would look carefully at the risk of a peso depreciation and its implications for our dollar-based return target, but our analysis would be aimed more at buying the shares after, rather than before, the devaluation (or, conversely, of exiting as such a risk arose).

Similarly to the Mexican silver miner, Japanese companies that were significant net exporters — and thus U.S. dollar or euro earners — benefited greatly from last year's yen depreciation. But for net importers, such as utilities that earned in yen but imported natural gas, coal, oil and uranium priced in U.S. dollars, the shoe was on the other foot and their earnings were hurt more than proportionally. Only for purely domestic companies like retailers or (most) banks, could earnings be said to move largely in line with the currency once it is translated back into our investor currency, the U.S. dollar.

Even then, company-specific revenue and cost trends are typically more important determinants of returns. And some "Japanese" companies missed out on the yen depreciation fun because — as a response to early yen overvaluation — they, like one "multinationalized" Japanese auto manufacturer, had become champions of … exporting from the (now higher cost) United States to Japan!

In fact, the great majority of companies whose stocks we invest in are multinationals, with revenues and costs in many currencies, especially in the case of European multinationals, with most of their business naturally hedged by having so-called "local for local" or "region for region" costs and revenues more or less matched around the globe. Several of our France- and Switzerland-domiciled companies, for example, have only 5%, 10%, or 20% of their business in France or Switzerland. (Indeed, several Swiss-quoted companies are formerly U.S.-based but highly multinational firms that have undergone an inversion, or formal de-domiciling from the U.S., largely for tax reasons).

Thus, we consider currencies as one — but usually far from the most important — determinant of most companies' long-term earnings and stock price potential, and we do our analyses accordingly.

The views expressed represent the Manager's assessment of the market environment as of April 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Diversification may not protect against market risk.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Dr. Lawrence G. Franko

Dr. Lawrence G. Franko biography

Dr. Lawrence G. Franko

Vice President, Senior Equity Analyst

Dr. Lawrence G. Franko has worked as a senior research analyst and advisor with the Global and International Value Equity team for more than 25 years and has an extensive background in global corporate competition and international financial management. His research responsibilities include financials, industrials, energy, and information technology. He joined Delaware Investments in June 2005. Dr. Franko was previously a tenured professor of finance in the College of Management at the University of Massachusetts, Boston. Simultaneously, he worked as an advisor to the team at Thomas Weisel Asset Management and ValueQuest/TA, where he was instrumental in developing the original international strategy. Dr. Franko has published several books and numerous academic papers on U.S., European, and Japanese multinational corporations. He has more than 30 years of investment and international business experience, including as professor of international business at IMI, a predecessor of IMD, in Geneva, Switzerland; at INSEAD in France; at the Tufts University Fletcher School of Law and Diplomacy; and as chief economist and director of currency advisory services at the Compagnie Pour le Financement et L’Investissement, S.A. (FINVEST) in Geneva, Switzerland. Dr. Franko earned a doctorate in business administration from the Harvard Graduate School of Business Administration. He also earned a master’s degree in law and diplomacy and a master’s degree in international economics from Tufts University’s Fletcher School of Law and Diplomacy, and a bachelor’s degree in economics from Harvard College.

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